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January 28, 2009

Bringing Down the House - What Blackjack can teach us about investing.

If you have read the book "Bringing Down the House" by Ben Mezrich or seen the movie "21" based on the book, then you are at least familiar with the system employed by a team of MIT students to beat the game of blackjack.  For those that have not seen the movie, the system is simple.  You have players sitting at several of the blackjack tables in a casino keeping a cumulative count of +1 for cards 2-6 and -1 for 10-Ace (cards 7-9 are 0 points).  The objective is to find tables with high positive counts, or said another way, a disproportionate amount of 10-Aces left to be dealt.  These tables have a very large positive probability-weighted return, so if you can find 10 tables with 10+ counts you would allocate a large portion of your total capital.  If every table has a negative count you don't bet or allocate any capital. 

Blackjack is much like investing.  The person placing bets based on the card count is the portfolio manager.  The tables are potential investments and the players sitting at each table counting cards are his analysts.  If the portfolio manager is having trouble finding positive probability-weighted return investments then the capital allocation should reflect the dearth of good ideas.  If the count is "positive" then capital should be deployed accordingly. 

Now let's take the analogy a bit further.  What if the dealers in the casino all of sudden starting reshuffling the decks after every hand?  This is not dissimilar to the situation that portfolio managers faced in 2008.  Every time they looked at their analysts for a card count, the landscape had changed.  In 2008 it was very difficult to come up with a trustworthy probability-weighted return for investments.  In a situation where the card count is difficult to determine a savvy investor will reduce their exposure.

All too often, I have seen situations where an investor will come up with their expectations for portfolio exposure and then allocate capital to assets.  That is a mismatch between the dependent and the independent variable.  The more logical approach may be to let the number of positive probability-weighted return investments (tables with a positive card count) determine portfolio exposure.  For instance, if it easy to find negative probability-weighted return investments, you have a pretty good sense of market valuation.  Take a step back, let the card count at all the tables dictate your exposure and not the other way around.

Here's to hoping that 2009 is full of loaded decks and single deck shoes.